8 Rules To Follow Before Borrowing Money From Family And Friends

I’ve written about lending money to friends and family. I addressed this topic a few years ago because as my personal financial situation improved, I was in a position to help. Not so long before that time in my life, however, I was in the opposite situation. I didn’t have my financial situation stabilised, and I was more likely to be in a position of need rather than a position of giving.More than 10 years ago, I was a borrower. I borrowed money from the government and its private partnerships to pay for college — just like many young adults. But after college, in a low-income non-profit job in one of the most expensive areas of the country to live, I wasn’t meeting my obligations. I found myself in financial trouble. (I say, “found myself” even though I know my situation was the result of my own actions; I didn’t “find” myself anywhere.)

I wasn’t in the habit of over spending, but even the necessities of living were just above what I could afford. I borrowed money to help pay expenses, including carried-over balances on my credit cards. I traded one debt for another. By the time I needed to create this chain of borrowing, I was moving towards a better financial situation, but I wasn’t there. It would still be several months before I had positive cash flow through a new job with a higher income and significantly reduced living expenses. This is before Consumerism Commentary, when I was learning about money management from places like the Motley Fool “Living Below Your Means” discussion board.

Even after I was in a much better financial situation a few years later, I still borrowed money. In 2004 I purchased a new car — against my general recommendation to buy used but the factors in play pointed towards a new car in my particular situation. The need for long-term reliability and no surprised directed me towards a reliable brand (Honda Civic) and a late model at that; certified used Honda Civics were only slightly less expensive than new cars, and the value seemed right to me.

I was planning to borrow money to pay for the purchase. I didn’t have $16,000 free to buy in cash, so I would need a car loan would to purchase a vehicle that met those needs. Rather than face a higher interest rate, my father offered to lend me the money to pay the dealer in cash. This would prove the be the last time I would borrow money from family or friends. If I remember correctly, I didn’t ask to borrow the money. We agreed on an interest rate that was less than I would have had to pay a bank and more than what my father would receive by placing the money in a typical brick-and-mortar bank savings account.

I paid the loan faithfully each month and when after I had generated some additional income for myself, I repaid the loan in full early.

Borrowing from family or friends can help you get out of a temporary, difficult financial situation. Asking for help requires some level of humility and willingness to be open and honest about your financial condition, and that can be difficult when personal finance is still a topic that most people avoid. When you take a personal relationship and turn it into a business relationship, there is a significant risk that your personal relationship will be destroyed. If you cherish your personal relationships, you should try to avoid borrowing money completely. Even if you pay the loan back in full and on time, it can change the nature of your relationship forever.

If you must borrow money from someone you care about, and I believe this option should be the very last resort when dealing with a personal finance shortfall and should be intended for only temporary situations, I suggest working under these guidelines or rules.

1. Ask for a loan from friends or family only after exhausting all other options.
Have you explored all other possibilities for improving your finances? A personal loan is the last thing you should do.

Before you ask for a loan, make sure you’ve already taken positive steps towards improving your finances. Track your spending to identify where you’re wasting money each month. Start a budget and follow it. Explore how you can earn more money on the side. Ask for a raise if your performance at your job warrants it — and if you have a job. Call your credit card companies and negotiate better interest rates.

You aren’t ready to take the responsibility of a loan from a friend or relative before improving your financial situation. If you were to ask for a loan from a bank, they would want to make sure you are prepared to handle the funds properly. A friend or family member is more likely to be affected by guilt and the desire to help, so the responsibility falls on the borrower to establish good habits in advance of borrowing, and exploring borrowing as a last option to bridge a small financial gap.

2. Pay interest.
Your lending-friend is only entertaining the idea to help you financially because they have the means and have a gracious spirit. They may offer to let you off the hook when it comes to interest. An interest-free loan is basically a gift. You can earn interest risk-free by depositing money in a bank. A lender willing to extend an interest-free loan is forgoing income in order to help you. it’s gracious, but as a borrower, it should be unacceptable.

Insist on paying interest at a rate at least the rate they’d be able to earn from a high-yield savings account. With today’s rates, refuse an offer of any loan lower than 2%.

3. Don’t negotiate.
If you have discussed your financial plight with your friend or relative and they have agreed to loan you money, don’t be ungrateful by trying to ask for more money or a lower interest rate. If you’ve identified a need for $10,000 and your friend is offering only $2,000, don’t ask for more; thank them and move forward. If they insist on charging a 5% interest rate, consider your other options, but if that’s your only possible avenue for meeting your short-term financial needs, agree to it.

recognise that this loan is not a balanced transaction. As a borrower who has explored other avenues and has turned to friends and family as a last resort, you don’t have the leverage to negotiate terms. If someone wants to do you a favour, either refuse or accept. Don’t negotiate.

4. Set up your loan documentation.
Create a spreadsheet that outlines the date and amount of each repayment. Share it with the lender so he or she knows when to expect your payments and when to expect the loan to be fully repaid. This is the calendar you and your friend or relative will stick to.

I am not going to advise for or against drawing up legal paperwork. That’s for the lender to decide. If the lender wants you to sign an agreement, do it. If he or she would rather keep the relationship informal, go ahead with that approach, but act as if the loan is a formal, legal relationship.

Once you agree to the terms of repayment, stick to it. Don’t be late with one payment. Don’t make excuses. You’re dealing with more than just a business transaction here, this is a personal relationship, the importance of which goes beyond finances. You don’t want money to be the issue that creates discord. If it’s easier, create automatic payments using your bank’s online check scheduling feature, or if you’d rather avoid technology and the risk of overdrawing your account if you’re not paying attention, set up email reminders for yourself using a tool like Google Calendar.

5. Don’t bother with peer-to-peer lender set-ups.
Tools like Prosper allow you to create personal loans. Prosper manages the payments and helps make the loan feel official. It’s an unnecessary step — and an unnecessary expense. Prosper will take a percentage out of each payment. There’s no need to get a third party involved. If the lender wants to set it up, you can still agree to the loan, but as a borrower, I wouldn’t suggest bringing up the topic.

Peer-to-peer lending, however, should be an option you explore before approaching friends and family for a loan. If it is legal in your state, seeking financial help using a site like Prosper or Lending Club can be one of your last resorts before a personal loan.

6. Pay the loan off early.
Make every effort possible to dispose of the loan sooner than you’ve agreed to. Most likely, your friend or family member agreed to lend you only as much money as they could afford to lose. That shouldn’t be an excuse to delay your repayment longer than necessary. If your financial situation improves before the end of the loan’s period, pay it off early. It will be a nice surprise, and on the personal relationship side, it might win you back “points” you may have lost.

At the very least it shows that you are not only a man or woman of your word, but you make extraordinary efforts to not only meet your obligations but outperform.

7. Return the favour or pay it forward.
Remember those who have helped you succeed. Someday, the person who was gracious to you might have his own problems to deal with. Offer yourself and your resources to the best of your ability. The favour paid to you — and it was a favour, not a money-making opportunity, even if you did pay interest — shows you the kindness of others, and you should reflect that attitude in your own kindness. If you are in the financial position to do so, help someone in need, whether the person who helped you, or someone else who could use it.

8. Don’t let your relationship be reduced to a financial transaction.
Friendships and personal relationships are the strongest bonds you can have with people. Within families, the bond is even stronger. If you’re introducing a financial relationship on top of a social one, everything will become more complex. That’s a result that you must weigh even before deciding to move forward with a loan.

Right now, I’m weighing the idea of going into business with a friend. It’s a decision I’m making very carefully, as many long-term friendships have been ruined by bad financial decisions. Whether with a loan or the potential for a multi-million dollar business, there are emotions to consider, and emotions are stronger when dealing with someone you’ve had a personal relationship with than they would be when dealing with an anonymous entity like a bank. Make an effort to maintain your current relationship with your lender. Don’t let all conversations be about the loan.

If I were planning to offer a friend or family member a loan, I would want them to read this article. As a lender, it can serve as discussion points. As a borrower, it should fit neatly into a code of ethics.

Have you borrowed money from a friend or family member? What were your experiences? Would you do anything differently? Are there any other rules you would suggest?

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